10 stock picks for sector-by-sector deflation

Overall inflation is very low in the world’s developed economies at an annual rate of 0.4%, 1.1% in the United States (if you use the Federal Reserve’s preferred price index for personal consumption expenditures) and 1.6% in the EuroZone. But that’s an average figure across these economies—many sectors are actually experiencing deflation. Not only can’t companies raise prices—even if the cost of raw materials climbs—but also they’re actually feeling pressure to lower prices because they do business in a sector with excess capacity where competitors are more than willing to cut price to keep their factories running. That’s true in sectors ranging from mining to semiconductor to TVs to solar cells. China, which has added huge amounts of new capacity even in sectors experiencing a glut of capacity, has been a major source of sector-by-sector deflation to date. And the evidence is that the problem is getting worse: net income from main business operations for Chinese industrial companies fell 2.3% in June from June 2013.

What does all these mean to you as an investor? That you can’t count on a rising tide of inflation to produce higher profits at all companies. Higher profits will be a) hard to come by, b) go to companies in those few sectors likely to escape inflation, and c) flow to those companies that can help their customers save money or increase profits in their battle with deflation.

What companies and stocks fit that profile? Here are my 10 picks for a deflationary global economy.

Precision Castparts (PCP)

Precision Castparts is a good template for the kind of company that can do well in a deflationary sector. The company has customers—Boeing (BA) and Airbus—that are extremely motivated to cut costs. At Boeing, for example, the complexity and multiple delays in the 787 Dreamliner program have raised the possibility that Boeing will sell a lot of planes but not make any money on the aircraft. One solution to that would be to simplify the supply chain that Boeing deals with for everything from jet engines to landing gear to fasteners, and to then put pressure on the resulting smaller number of suppliers to wring costs out of their business. Precision Castparts has been aggressively rolling up suppliers in the sector and finding efficiencies to improve margins (and leveraging its size to increase sales for the companies it acquires.) In the just reported June quarter the company grew EBIT (earnings before interest and taxes) margins to 27.2%, a one-percentage point gain. Margins in the casting segment (34.6%) and in the forged product segment (25.1%) were both records for the company. The stock is a member of my Jubak’s Picks portfolio http://jubakpicks.com/ . I recently raised my target price to $242 a share. (For more on the company and stock see my July 31 update http://jubakpicks.com/2013/07/31/precision-castparts-is-a-stock-pick-to-buy-on-the-dip-and-wait-for-growth-to-pick-up-in-2014/ )

Middleby (MIDD)

Middleby pursues the same strategy as Precision Castparts only the company has been doing it longer and in a more fragmented industry, the restaurant and food preparation sector. Here’s what the company does: It acquires a smaller specialized maker of kitchen equipment for the food industry such as Nieco, a maker of automated broiler equipment, or Stewart Systems, a maker of bakery equipment, using its size and management skills it finds way to cut costs in those acquisitions while also increasing sales from those acquired businesses by leveraging its existing customer base. And quite a customer base it is too: Middleby has the #1 market share in equipment for pizza chains, #1 in convenience stores, #1 in fast casual, #1 in chicken outlets—you get the idea. In fact, the only mass-market restaurant segment that I could find where Middleby wasn’t No. 1 was a #2 position in the quick service (fast food) segment. Where will Middleby’s growth come from? Continued penetration and consolidation in the still fragmented U.S. market for restaurant equipment plus a move into international markets. There Middleby’s history of working with restaurant customers to understand what equipment will work for them and then delivering it is important. Middleby isn’t going to attempt to jam U.S. style equipment down the throats of non-U.S. restaurants, but instead will use its investment in R&D to come up with products suited to individual international markets. For India and China, for example, Middleby has rolled out tandoor ovens, samosa fryers, and rice steamers. (International markets now account for 31% of sales.) The other source of growth for Middleby is in the industrial food processing and baking segment, now 30% of sales. What makes Middleby suited to a deflationary economy? The goal of each generation of product innovation is to raise customer satisfaction with the food product delivered by the restaurant or food processor and at the same time to lower costs by cutting time out of the preparation process by, for example, lowering the time from order to food delivering—what is known as ticket time. I added Middleby to my long-term Jubak Picks 50 portfolio http://jubakpicks.com// on May 3.

Cummins (CMI)

Cummins makes diesel engines for the heavy (Big Rig) and middle-duty (school buses, for example) market. So how does that fit into my deflation theme? Because Cummins invests so heavily in research and development, it’s new diesel engines are far more energy efficient than those on trucks even a few years old. The average age of the Class 8 fleet, that’s the Big Rig market, hit 6.6 years in March 2013. In 2010 the average Class 8 truck averaged 6.1 to 6.2 miles per gallon. In 2013 the average new truck came in at 8 mpg. Industry estimates put the annual savings at 4,200 gallons of fuel a year or about $17,000 per truck. Add in regulations mandating lower emissions that are spreading from developed to developing economies and you’ve got a health replacement market driven by cost savings and environmental rules. In the last decade Cummins has picked up 10 percentage points of market share in the U.S. heavy-duty engine market. I think that trend is likely to continue. I also like the company’s leading position n developing natural gas powered truck engines—with U.S. natural gas prices so low conversion to natural gas as a fuel makes sense for owners of truck fleets. The company’s engine for heavy-duty trucks hit the market in 2013 and its medium duty engine (for school buses, for example) is scheduled for 2015. Cummins is a member of my long-term Jubak Picks 50 portfolio http://jubakpicks.com//

Industrias Bachoco (IBA)

I can’t think of a lot of sectors safe from deflation—but food is definitely one. Food producers don’t have to worry about global overcapacity. In fact the worry is a long-term lack of global supply as the world struggles to produce enough food for a growing population of 7.1 billion on August 5, 2013, up from 6.3 billion in 2003 and headed to 7.8 billon in 2023. And, of course, as incomes rise in the developing world, people there will want to eat more food and better food with an increasing demand for protein. (Protein production consumes a huge amount of grain with grain-fed beef requiring 7 pounds of grain to produce a pound of beef. For pork the ratio falls to 3 pounds of grain for a pound of pork. For chicken the ratio is about 2 to 1.) All this extra food has to be produced on less land—as buildings and deserts encroach on farmland—and with a falling supply of clean water. I think we may see temporary drops in food prices as big harvests send commodity prices downward, but over time, the trend in food prices is up. Industrias Bachoco is Mexico’s largest poultry producer (and its No. 2 producer of eggs) with a 35% share of the Mexican market chicken market and a 10% share of the egg market. In 2011 the company bought OK Industries, a U.S. chicken producer to increase its market share in the United States.

BRF (BRFS)

To understand the upside leverage for a company that produces protein when food prices are climbing and prices for grain, the major input in protein production, are falling look no further than the second quarter results from BRF, Brazil’s second largest food company by revenue. Net income rose by 33 times and EBITDA (earnings before interest, taxes, depreciation and amortization) climbed to 910 million Brazilian reais (excluding one time items.) That beat the consensus projection of 841 million reais. Earnings soared as prices for domestic meat rose by 18% and the cost to feed chickens and pigs fell with a decline in soybean prices. (Protein production at BRF breaks down this day: poultry 34% of sales, pork and beef 9%, dairy 9%, and processed products 40%.) The company owns two of the best brands in Brazil, Sadia and Perdigao, and one of the few nationwide refrigerated distribution systems. But the big growth is likely to come in exports—43% of sales at the beginning of 2013. Exports grew by 31% year over year in the first quarter of 2013.

Cheniere Energy (LNG)

If you’re a company looking to cut costs in a deflationary sector, where do you look? How about energy? It’s a huge cost for many companies in sectors experiencing the worst competitive pressures from overcapacity. And right now the world is characterized by huge disparities in prices among energy markets thanks the boom in U.S. production of natural gas and the difficulty of exporting more than a fraction of that production. Natural gas sold for $3.33 per million BTUs in the United States in August, but the landed price of liquefied natural gas was $9.46 per million BTUs in the United Kingdom and $15.75 in Japan. So how does a company take advantage of this price disparity? You can move production to the United States as some chemical producers, such as LyondellBasell (LYB) have done. Or you can root for Cheniere Energy to finish its liquefied natural gas export facility ahead of schedule. Cheniere was the first company to get a license to export liquefied natural gas from the United States and it is on schedule to start shipping gas from the United States in 2015. Recently a second export project got a license in the United States, but that project isn’t scheduled to start exporting natural gas until 2017. That gives some idea of the lead-time that Cheniere has before other U.S. suppliers get into the market. The thing I like about Cheniere in the current economic environment is that the stock should go up, without any need for higher global economic growth to drive up natural gas demand or prices, as Cheniere gets closer and closer to first ship date. (Cheniere has another project waiting license approval as well.) As long as the project stays on schedule, the stock should climb. Cheniere Energy is a member of my Jubak’s Picks portfolio http://jubakpicks.com/

Chesapeake Energy (CHK)

Maybe the best news that Chesapeake Energy reported for the second quarter on August 1 was no growth in natural gas production from the first quarter. It indeed does look like the U.S. natural gas industry, after expanding itself to near collapse, is seeing production growth slow. Natural gas production in the United States will grow by just 1% in 2013, according to the U.S. Energy Information Administration. That’s a big drop from the 8% growth of 2011 and the 4% growth in 2012. And that looks like it will push natural gas prices higher. Standard & Poor’s is projecting Henry Hub spot prices will average $5.00 per million BTUs (British Thermal Units) in 2014, up from $2.58 in 2012 and a projected $3.72 in 2013. Natural gas for August delivery closed at $3.33 per million BTUs on August 2. Low prices for natural gas are encouraging an increase in demand as companies switch fuel or relocate to take advantage of low U.S. natural gas prices. Cuts to capital spending and an increased emphasis on production of oil and natural gas liquids rather than natural gas itself increase the odds that Chesapeake Energy will be around to see prices rebound. (Net debt in the second quarter fell to $12.4 billion from $13.4 billion.) Chesapeake Energy is a member of my Jubak’s Picks portfolio http://jubakpicks.com/

Amazon.com (AMZN)

I can think of three ways that Amazon.com is a good match for a world with strong deflationary pressures. First, the company is a way for businesses to cut distribution and selling costs. Let Amazon be your storefront is an increasingly attractive option to third-party sellers. In its June quarter the company saw unit volumes from third-party sellers climb 29% year over year. Second, cloud computing is a way for companies to save on their software and computing costs. Amazon Web Services, the division that includes Amazon’s servers hosting cloud computing for other companies, saw $1.6 billion in revenue and is projected to grow revenue by 30% annually over the next five years. And, third, Amazon offers consumers squeezed by stagnant incomes and deflationary pressures an easy way to shop for the lowest price. And the company’s free shipping options are a powerful method for building loyalty and traffic among price conscious consumers.

eBay (EBAY)

eBay is betting that it can successfully compete with Amazon because 1) it can provide a more attractive neutral marketplace to third party sellers since it doesn’t compete with them by selling itself, 2) because the PayPal payment system will bring in a steady steam of revenue from transactions (especially, going forward, from mobile transactions) and from sales by third party sellers who use PayPal as a payment platform, and 3) because it can use PayPal and its existing electronic marketplace to at least duplicate and perhaps even one-up Amazon’s free delivery option with a same-day, $5 delivery service called eBay Now. The service promises delivery from local stores—thus continuing eBay’s theme of not competing with third party sellers. The service, now in beta in selected cities, would let eBay duplicate—to some degree—Amazon’s expensive constructed warehouse delivery system without spending the company’s own money on bricks and mortar. It remains to be seen if eBay can make significant inroads into Amazon’s huge lead in this space, but in a deflationary environment I think the market can certainly support two digitally based retailers. eBay is a member of my long-term Jubak Picks 50 portfolio http://jubakpicks.com//

Costco Wholesale (COST)

And on the evidence of recent quarters there’s at least one brick and mortar retailer, Costco Wholesale, that’s likely to do well if consumers feel squeezed by deflation. I can’t think of another retailer so successful at charging consumers a membership fee to shop. In the recently reported third quarter the company reported a 19% year over year increase in memberships (with a boost from new store openings in Japan, the home of deflation.) Renewal rates were 86.4%. And this comes after the company raised membership fees in November 2011. Let’s see: consumers are will to pay—and pay more—for the right to shop at Costco with the idea that even after the membership fee they’ll save money. And apparently—to judge from renewal rates—they’re happy with the experience. Same store sales rose 7% in the quarter. An extended bout of slow economic growth and stagnant incomes should, if the U.S. experience is any guide, help power Costco’s international expansion. The company has been slow to expand outside the United States, waiting to see if it could duplicate the returns from the U.S. operation overseas. I think the answer to that question is now in: The company’s international stores look to be generating sales of around $900 a share foot. That’s lower than the $960 a square foot in the U.S. but still about two times higher than Wal-Mart’s sales per square foot, according to Morningstar’s calculation. That means that Costco’s international expansion, unlike those of its competitors, so far actually generates a return above its cost of capital. Investors then should see any international plans for expansion at Costco as opportunities to make money in the present and not as investments in the hope of profits some day.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , I liquidated all my individual stock holdings and put the money into the fund. The fund did own shares of Cheniere Energy, Chesapeake Energy, Cummins, eBay, Industrias Bachoco and Precision Castparts as of the end of June. For a full list of the stocks in the fund as of the end of June see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/